Bond Yields and Bailout Guarantees: Regional Debt Markets in Germany

In July 2012, MOODY’S INVESTORS SERVICE “changed the
long-term rating outlooks of six German states to negative from
stable, citing the close fiscal ties between the regions and the
federal government, whose outlook was downgraded two days
ago”. The change in outlook applied to the German states of
Baden-Württemberg, Bavaria, (the two most productive states of
Germany in terms of GDP/capita) Berlin (at the same time the largest
city in Germany), Brandenburg (situated in former Eastern Germany
and characterized by one of the least developed economies in
Germany), North-Rhine-Westphalia (the largest state in Germany in
terms of population and territory), and Saxony-Anhalt (like
Brandenburg the state of Saxony-Anhalt is situated in Eastern
Germany with relatively low GDP per capita).
MOODY’S change in outlook can be interpreted as decisive
rethinking within the framework of German fiscal federalism as it
puts the financial health of single regions (Laender) as independent
entities on the spot. Prior to 2010 rating agencies such as FITCH
had not even issued region-specific ratings due to assumptions that
German regions enjoyed (unconditional) bailout guarantees of the
federal government. Does MOODY’S action thus reflect changes
in assessments of risks within Germany’s system of fiscal
federalism, which are going to increase borrowing costs of German
regions? Some German politicians seem to think that this may well be
the case. In March 2012, OLAF SCHOLZ the social-democrat mayor and
head of state of Hamburg, the second largest city-state in Germany
in terms of population, proposed the introduction of
“Deutschland-Bonds”, i.e. bonds that are commonly issued
and guaranteed by German states and the federal government.
SCHOLZ’ approach was also promoted by RAINER WIEGARD, then
Schleswig-Holstein’s Finance Minister and a member of the
CHRISTIAN DEMOCRATIC UNION. Politicians of other regions and the
federal government followed suit. The first
“Deutschlandbond” will be issued in 2013. As of the
writing of this essay, their structure and volume has not been
decided.
What will be the impact of “Deutschlandbonds”? Will they
lower state-borrowing costs through introducing new federal bailout
guarantees? Or will changes be miniscule as investors assume that
these guarantees exist anyway? Viewing the financial crisis of 2008
– 2010 as natural experiment that tested investors’
assumptions with respect to the existence of bailout guarantees on
state-level debt in Germany, the essay discusses the question, in
how far the introduction of “Deutschlandbonds” is likely
to have a significant effect on borrowing costs of German regions.
If investors perceived of federal and regional bonds already as
close substitutes due to common bailout guarantees, then – so
the reasoning of this essay – the introduction of
“Deutschlandbonds” will be of limited effect to
borrowing costs in regional debt markets.